Tax-deferred status refers to investment earnings such as interest, dividends or capital gains that accumulate tax free until the investor takes constructive receipt of the gains. The most common types of tax-deferred investments include those in individual retirement accounts (IRAs) and deferred annuities. Tax deferral allows growth to be compounded on the portion of earnings not forsaken to investment taxation.
By deferring taxes on the returns of an investment, the investor benefits in two ways. The first is tax-free growth. Rather than paying tax on the current returns of an investment, tax is paid only at a later date, leaving the investment to grow unhindered. The second benefit of tax deferral extends to investments made during pre-retirement periods when earnings and taxes levied against working wages are typically higher than earnings in post-retirement phases. Withdrawals taken from tax-deferred investment accounts occur when a person is earning less taxable income and the tax rate realized by an individual is usually lower than the rate applied during the employment phase.
A 401(k) plan is a common vehicle offered by employers to grow employees’ retirement savings. Companies utilize a third-party administrator to manage contributions deducted from employee earnings. Employees choose to invest savings among various options: mutual funds, company stock or fixed-rate options. Gains attributed to securities held within the 401(k) do not apply to the employee’s taxable income. Contributions to qualified savings plans such as 401(k) accounts are made on a pre-tax basis, reducing taxable income received by the employee.
Withdrawals made from qualified retirement plans, generally after age 59.5, are taxed at the investor’s individual tax rate at the time of receipt. An investor with a 33% tax bracket on employment wages may pay 10 or 15% tax on amounts taken from 401(k) plans used to supplement retirement income from savings, interest and government subsidies. Tax-deferral and employer dollar-matching provisions encourage employees to set aside wages to grow a retirement nest egg, putting off receipt of funds to a period in which tax rates are theoretically lower.
A nonqualified tax-deferred investment does not reduce taxable income but allows capital gains and interest to grow unencumbered. Annuities are a popular insurance product embracing the benefits of tax deferral. While qualified retirement plans such as traditional IRAs limit contribution amounts to $5,500 annually, many annuities do not restrict contribution amounts. A $1 million fixed annuity contribution with a guaranteed 2% interest rate backed by an insurance company allows earnings to accumulate without being taxed by the Internal Revenue Service (IRS). The $20,000 in interest grows without the IRS levying taxes against the earnings, allowing the full amount to compound in the second year of the annuity contract. A money market investor in a 33% tax bracket, realizing the same interest rate, would owe $6,666 in tax to the IRS as earnings are treated as ordinary income. Interest received after age 59.5 avoids an IRS penalty for early withdrawal, which is a 10% assessment against interest earned.